RetireMentors

Tax Planning

How "tax-loss harvesting" can actually raise taxes

Dan Moisand,
a Principal at Moisand Fitzgerald
Tamayo, LLC in Melbourne and Orlando, Fla., is one of the financial
planning profession’s most respected practitioners advising retirees and near
retirees. Dan’s thoughts can be found in bylined articles in most major
publications for financial planners and a slew of financial planning related
publications have featured him as one of America’s top advisors and was recently
named one of
"15
transformational advisers" by InvestmentNews. A past national
President of the Financial Planning Association (FPA), his service to the
profession includes three years on the CFP Board of Practice Standards crafting
the standards to which all US CFP’s must adhere and serving as Chairman of the
CFP Board’s Discipline and Ethics commission, the body that judges complaints
against CFP licensees. A frequent presenter at such events in the U.S., Dan has
spoken to planner groups on five continents and in recent years has led
delegations of U.S. planners to Russia and China on behalf of the FPA.

Whenever markets drop, certain topics come up. Tax-loss harvesting is one of these that seem to be smart. In certain situations, however, tax-loss harvesting can actually increase a family's tax burden.

Q.With the recent market drop, I've seen a few stories about "tax loss harvesting." Seems like a no-brainer.

A. I've gotten a few versions of this question lately. That's probably because when prices fall, tax-loss harvesting gets a lot of play. It can be helpful but not for everyone. Here is my basic example.

Say you buy "ABC" for $50,000 and ABC drops 20%, you may opt to "harvest" the loss by selling ABC for $40,000 and buying a similar holding "XYZ" with that $40,000. If XYZ and ABC are similar enough, both your basic investment position and your investment plan is intact, but you have a $10,000 loss for tax purposes. For many, this will save some tax dollars but not in all cases. Beware: If ABC and XYZ are too similar, "wash sale" rules will disallow the loss.

First, the transaction does nothing when it occurs in a retirement plan, IRA, annuity contract, 529 savings plan, or even within a life-insurance policy.

Second, tax law makes you use the loss to offset capital gains. To the extent you are in a 15% marginal bracket or lower, the tax rate on long-term capital gains is zero. The loss would be used to offset nothing, tax-wise. The loss would have no value to such taxpayers.

Third, the harvest is not a free lunch. Future gains will actually be greater because the basis in XYZ is only $40,000 in our example.

In cases where the losses exceed the year's gains, you can use $3,000 against your ordinary income on your current year 1040. The value of that depends on your marginal tax bracket. You would then "carry forward" $7,000 of losses to the following year.

As I mentioned, your position in XYZ now has a basis of $40,000. If XYZ appreciates to $50,000 and is sold, you incur a $10,000 gain. If you had held ABC the whole time, there would be no gain. You paid $50,000 and got $50,000.

By harvesting the loss, your gross return is also zero. You bought ABC for $50,000 and sold XYZ for $50,000. However, in between you realized a $10,000 loss and a $10,000 gain.

The loss and the gain can be taxed at very different rates.

To make things more complex, most people have several holdings and multiple tax lots. Over time, you can face multiple possible tax rates as your income fluctuates, gains and losses are realized, and the years pass.

Complexity can bring multiple planning opportunities, or pitfalls. As a general principle, the higher your current bracket relative to your anticipated future bracket, the more likely the tactic will pay off.

Tax-loss harvesting is often presented as a short-term tactical decision but really it should be considered as part of a long term strategic plan.

Dan Moisand's comments are for informational purposes only and are not a substitute for personalized advice. Consult your advisor about what is best for you. Some questions are edited for brevity.

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